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The Looming Threat That Could Initiate the Next Economic Collapse

Lurking behind the big banks is a mess of unregulated finance that could trigger the next financial blowup.

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The Commodity Futures Modernization Act of 2000 explicitly exempted over-the- counter derivatives, such as the ones that caused so much trouble for AIG, from regulation. Yet now, nearly four years after the AIG fiasco, regulations have yet to be implemented to prevent a repeat of the daisy chain of derivative counterparty failures requiring a bail out.

The financial crisis caused many derivatives to blow up in highly unpredictable ways, which had serious consequences for those that bought them. The U.K. has forced financial firms to make good on mis-sold swaps—those sold to customers that didn’t understand the products they’d been led to purchase. The U.S. has yet to adopt rules to protect customers from abusive practices, including excessive hidden fees and lack of suitability for intended purpose, that caused major hardships to small businesses, charitable institutions and state and municipal governments.

The financial world has been rocked this summer by allegations that the big banks that set the London Interbank Offered Rate (LIBOR) colluded in fixing the rate, in ways that suited the interests of these banks. LIBOR is used to set the interest rates used in calculating trillions of dollars worth of derivatives contracts.

Amazingly, banks themselves have been left alone in setting these rates, supervised only by a private organization, the British Bankers Association (BBA). The  Wall Street Journal reported recently on how throughout the financial crisis, major banking regulators in the U.K. and the U.S. went out of their way not to confront the LIBOR problem. 

They recognized the banks were manipulating the rate. Such shenanigans affected the value of derivatives contracts—the amount charities, government, and companies paid for various types of protection against financial risk that they’d purchased. These rate manipulations benefitted banks, not the entities on the other side of the contract.  But the regulators refused to get involved. After all, the BBA was part of the shadow banking system, so no one was in charge.

Home alone

Despite huge public investment in regulation, there is no single U.S. government agency responsible for the stability of the financial system. Dodd-Frank established a new Financial Stability Oversight Council (FSOC) to coordinate regulation. But this committee formed of all the regulators who were unable to prevent the last crisis—plus some new ones-- is clearly an unwieldy structure for addressing the challenges the U.S. now faces. The FSOC retains all those regulatory fiefdoms that refused to surrender their independence, and be folded  into an overarching organization that could regulate effectively. Europe’s done a better job at addressing these problems, with some countries adopting a “twin peaks” model—where one regulator worries about the stability of the financial system, and the other regulates the market activities the banks get involved in.

Today, the FSOC faces a crucial test. Shapiro has asked this group to step in where her agency failed. Money market funds have proven to be banks without capital that in 2008 caused a run that required a government bailout to arrest. Dodd-Frank prohibits future bailouts. The SEC is unable to regulate a set of major savings institutions that savers and corporations depend upon. Will the FSOC step into the breach? Or will shadow banks continue to be home alone without any supervision?

Caution, here be monsters!

Regulators have largely passed the buck to the shadow banking system. Rather than making regulations that ensure the safety and soundness of financial institutions, and safeguard the stability of the financial system, the riskiest activities are pushed away, out of sight, into the shadows.

But shooing these monsters off into the shadows doesn’t kill them. The shadow banking system rivals the regulated banking system in size and overwhelms it with risk. The regulatory net has big holes in it and enough has already slipped through. We already have a  great recession. We are reminded that it could have been worse. So why are waiting for shadow banking monsters to devour the economy— and your job, your savings, your community — again?